Research analyzes exchange rates in 34 countries and proposes a new economic model

The exchange rate is one of the most strategic macroeconomic prices, directly influencing foreign trade, the purchasing power of the population and the competitiveness of companies. However, its determination is still the subject of debate among economists. The article by Luiz Carlos Bresser-Pereira, from FGV EAESP, Carmem Feijó and Eliana Araújo proposes a new model to understand the factors that determine the real exchange rate, differentiating between the short and long term.

The researchers developed a theoretical model and tested it empirically in a study covering 34 emerging and G7 countries from 1998 to 2017. The researchers carried out econometric tests to verify the relevance of the proposed variables and their predictive capacity in relation to the exchange rate. The journal Structural Change and Economic Dynamics published the full study.

The model starts from the premise that the exchange rate revolves around the Value of Foreign Currency (VME), which reflects the value of goods and services that a currency can purchase in another country. Therefore, unlike the traditional Purchasing Power Parity (PPP), the EMV takes into account market dynamics and capital flows.

In addition, four variables are essential for determining the long-term exchange rate:

1. Terms of trade: Changes in relative prices between exports and imports directly influence the exchange rate.
2. Current account balance: Recurrent deficits tend to overvalue the currency, while surpluses depreciate it.
3. Interest rate differential: Higher interest rates attract foreign capital, leading to currency appreciation.
4. EMV: Defines a center of gravity for the exchange rate, ensuring competitiveness for companies that use cutting-edge technology.

The empirical results showed that the current account balance is the most influential variable in determining the exchange rate. When a country maintains recurrent deficits, its currency tends to be artificially valued, while sustained surpluses favor a competitive exchange rate. The study also identified that the influence of unit labor costs is relevant to external competitiveness and may require exchange rate adjustments to offset losses.

The research contributes to the debate on exchange rate policy by suggesting that countries with recurrent current account deficits tend to maintain an overvalued currency. This would harm industrial competitiveness. By proposing to replace the PPA with the concept of the EMV, the authors offer a more realistic approach to understanding the behavior of the exchange rate. The proposed model can serve as a useful tool for economic policymakers seeking to ensure a sustainable exchange rate equilibrium. Ultimately, this would also promote long-term economic growth.

Read the full article.

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